Agency Costs, Mispricing, and Ownership Structure

by Sergey Chernenko, C. Fritz Foley and Robin Greenwood

Executive Summary —
Under what circumstances do firms access capital markets when the potential for agency costs is high? The prevailing view holds that controlling shareholders sell shares to outsiders only when internal capital is inadequate to fund attractive investment opportunities. While the role of market efficiency in corporate finance has attracted considerable research attention, the interaction of stock market mispricing with agency problems is not well understood. HBS doctoral graduate Sergey Chernenko and professors C. Fritz Foley and Robin Greenwood propose a new explanation—based on stock market mispricing—for why firms with a controlling shareholder raise outside equity, even when firms cannot commit not to expropriate minority shareholders. Key concepts include:

Stock mispricing offsets agency costs and induces a controlling shareholder to raise capital. Higher misvaluations are required to support the creation of ownership structures that give rise to more expropriation.

To the extent that agency costs are deadweight instead of distributional transfers, mispricing facilitates the creation of inefficient ownership structures.

Author Abstract

Standard theories of corporate ownership assume that because markets are efficient, insiders ultimately bear agency costs and therefore have a strong incentive to minimize conflicts of interest with outside investors. We show that if equity is overvalued, however, mispricing offsets agency costs and can induce a controlling shareholder to list equity. Higher valuations support listings associated with greater agency costs. We test the predictions that follow from this idea on a sample of publicly listed corporate subsidiaries in Japan. When there is greater scope for expropriation by the parent firm, minority shareholders fare poorly after listing. Parent firms often repurchase subsidiaries at large discounts to valuations at the time of listing and experience positive abnormal returns when repurchases are announced.
50 pages